What is the prime rate?
The prime rate is the interest rate applied by commercial banks to their most solvent client companies. The overnight federal funds rate is the basis for the prime rate and the prime rate is the starting point for most other interest rates.
Understanding the prime rate
The prime rate is the interest rate that commercial banks charge to their most creditworthy customers, usually large corporations. The prime interest rate, or prime interest rate, is largely determined by the federal funds rate, which is the overnight rate that banks use to lend to each other. Prime rate is the basis or starting point for most other interest rates, including mortgage, small business or personal loan rates, although the prime rate may not be specifically quoted as a component of the rate ultimately applied.
Interest rates cover the costs associated with the loans and compensate for the risk assumed by the lender based on the borrower’s credit history and other financial details.
The prime rate, plus a percentage, forms the underlying basis for almost all other interest rates.
Determine the prime rate
The risk of default is the main determinant of the interest rate that a bank charges a borrower. Because the best customers of a bank are unlikely to default, the bank may charge them a rate lower than the rate they charge a customer who is more likely to default on a loan.
Each bank sets its own interest rate, so there is no single prime rate. Any prime rate quoted is generally an average of the prime rates of the largest banks. The most important and most used prime rate is the one that the Wall Street newspaper publishes daily. Although other US financial services institutions regularly note any changes the Federal Reserve (the Fed) makes to its prime rate and can use them to justify changes to their own prime rates, institutions are not required to increase their prime rates in accordance with Fed’s.
Preferential rates and variable interest rates
In the case of variable interest rates, such as those used on certain credit cards, the interest rate of the card can be expressed in prime rate increased by a defined percentage. This means that the rate increases and decreases with the prime rate as the underlying base rate, but will always remain a fixed percentage higher than the prime rate.
Prime rate and best qualified clients
As a general rule, the prime rate is reserved only for the most qualified customers, those who present the least risk of default. Prime rates may not be available to individual borrowers as often as to large entities, such as corporations and particularly stable businesses.
Even if the prime rate is set at a particular percentage, say 5%, a lender can still offer rates below 5% to well-qualified customers. The prime rate is used only as a reference, and although it is probably the lowest advertised rate available, it should not be considered a mandatory minimum.
Key points to remember
- The prime rate is the interest rate applied by commercial banks to their most solvent client companies.
- Mortgage, small business and personal loan rates are based on the prime rate.
- The most important and most used prime rate is the one that the Wall Street newspaper publishes daily.